Hedge Fund Hell: Banks Jockey For Position

Battered hedge funds may still be the best-looking clients out there for banks, which face a dearth of opportunities to do deals in the dead M&A and IPO markets.

The business of providing an array of services to hedge funds, known as prime brokerage, went up for grabs in 2008. It is highly specialized, expensive, and difficult to run, but potentially very lucrative. It typically accounts for about 6% of Goldman Sachs' (GS) revenues, though that does not include ancillary benefits, like trading commissions.

In the fourth quarter, Goldman's first money-losing effort as a public company, prime brokerage helped offset some of the damage. The $799 million the business accounted for some 15% of total revenues.

Potentially even more lucrative for prime brokers -- though dicey -- is their access to privileged information and levers of power. For example, when hedge fund Amaranth Advisors got into trouble on natural gas trades in 2006, JPMorgan Chase (JPM), an important financial backer to the hedge fund, took over the trading positions and sold them for a profit of $725 million. The situation is the subject of an ongoing lawsuit, in which Amaranth blames its ultimate failure on JPMorgan.

Until 2008, the equity prime brokerage business was dominated by Goldman and Morgan Stanley, (MS), with Bear Stearns a distant third and a handful of other firms bringing up the rear, according to Sandler O'Neill analyst Jeff Harte. Bear's failure in March gave acquirer JPMorgan an opportunity to break into the top tier, and subsequent concerns over the financial soundness of Morgan Stanley and Goldman caused some of their hedge fund clients to flee.